Interest rates took a hit almost immediately after coronavirus fears emerged. As businesses closed and the economy came to a standstill, the Federal Reserve (Fed) took immediate action to help the economy as much as they could. The Fed Funds Target rate was cut from 1.75% to 0.25% in under a month. The long end of the yield curve followed suit with the result being yields across the curve declining. The lower rate environment in itself would be enough to spark discussion at banks regarding bank balance sheet strategy.
Source: Bloomberg, 2020
A sharp decline in market rates was not the only impact from the coronavirus. At the same time, banks saw their balance sheets start to balloon with an influx of deposits. Stimulus money, Paycheck Protection Program (PPP) loans, and flight-to-safety all played a role in large amounts of cash ending up on bank balance sheets at levels never seen before. The Fed reported cash assets on balance sheets at a level of $3.3 trillion during the second quarter. This is more than three times the levels experienced during the last financial crisis.
On the surface, loan demand looks strong, however most of the loan growth has come in PPP loans with consumer loan balances declining over the same time period. Banks made more than $500 billion in PPP loans during the second quarter. As that program comes to an end, all signs point to slower loan demand. This trifecta of lower rates, influx of deposits, and faltering loan demand has put a squeeze on net interest margins. U.S. Commercial and Savings Banks reported a median net interest margin of 3.26 for the second quarter of 2020. This is down from 3.61 the prior year. Third quarter results have yet to be released, but we would expect net interest margin to be compressed even more.
Source: S&P Global Market Intelligence, 2020
Bank stress testing is essential in navigating times of crisis
Looking forward, the uncertainty of the economic outlook, which in large part is dependent on the course of the coronavirus, leaves many unanswered questions. In saying that, balance sheet stress testing is as important as ever. Simple stress test modeling can give insight in forming balance sheet strategies that will benefit the bank both in the short-term and long-term. It can help identify risks as well as provide valuable information to make informed decisions regarding balance sheet structure and rate setting. Stress tests are a useful tool to assess the bank health under varying financial and macroeconomic conditions and are essential in guiding banks in their decision making.
Liquidity stress testing proves valuable in the current rate environment
Given the current environment, banks are left with decisions on what to do with all the excess cash currently sitting on balance sheets. Liquidity stress testing has been a hot topic for a while. Typically, when we think of liquidity stress testing, it is to evaluate the bank’s position if there is a significant shortage of cash and liquidity. Even with banks flush with cash, there is a benefit of running this type of analysis in the current rate environment.
Below is an example of a liquidity run-off scenario compared with a standard earnings projection. In this liquidity scenario we modeled a 10% run-off of deposits and funded it first with excess cash and then with a short-term borrowing. In a base case environment, meaning interest rates remain unchanged, the bank performs better if there is a run-off of deposits. This makes sense given the current rate environment. Many financial institutions are paying higher rates on their deposit accounts than they can earn in an overnight cash account or what they would pay in a short-term borrowing. In the example, it takes interest rates moving up 200 basis points (bps) before the earnings from the standard run outperform the deposit run-off scenario. The results certainly raise some questions on deposit pricing and can serve as a guide for discussion and decision making. Liquidity scenarios like the one below can be run with funding coming from a variety of funding sources.
Managing deposits and excess cash amidst an unknown future
Most banks would welcome some run-off of the excess deposits right now, but what if that is not what happens? Deposit stickiness will vary bank to bank and is something to be discussed internally. There is also the possibility of a second round of stimulus which could inflate deposit balances even more. Given the current environment and deposit levels, it makes sense to evaluate deposit pricing and strategize at what level most make sense. The most common fear with lowering deposit rates is a departure of some of those deposits from the balance sheet. However, that might make sense given the current environment and the realization that deposit run-off could possibly benefit earnings. Whether there is run-off or not, the lower rate would benefit net interest margin. Comparing deposit rates to wholesale funding rates can give some insight on how those deposits should be priced.
There is still the question on what to do with the excess cash that remains. For now, a lot of banks have been letting those funds sit in an overnight investment. Issuing loans is ideal if the demand and credit can be found. Paying down current borrowings is another option to consider. If you do have term borrowings on the books, now would be a good time to look at paying those off. The second modeling example here looks at the impact of using the excess funds on the balance sheet to pay down borrowings. In this example, borrowings were reduced from 15% to 10% of liabilities. The results are even more significant with the pay-down scenario showing an earnings advantage over the current balance sheet earnings projections up until reaching the +300 bps shock.
Of course, it is important to look at the long-term effects as well. In the same scenario, economic value or equity (EVE) looks better in the base case environment, but reducing the term borrowings introduces greater volatility in the rising rate environments. As always, interest rate risk management is a balancing act.
These are just a couple of examples of ways to use your interest rate risk modeling to enhance your decision making. Other scenarios we are running frequently now include loan stress tests, recession scenarios, and non-parallel rate movements. The options for what-if modeling/stress tests are limited only by your imagination. All provide valuable decision-making data.
As the rate environment and balance sheet structure changes, modeling the impact to bank performance can help evolve the discussion of balance sheet strategy. By knowing and evaluating the consequences of strategies, banks are able to make better, more informed decisions regarding balance sheet management.
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